TAX BRIEF

INDIVIDUAL

The IRS released revenue procedure 2002-22 in March to address the use of fractional ownership interests as replacement property in IRC section 1031 exchanges. Commonly referred to as “tenancy-in-common” or TIC interests, these fractional interests offer significant advantages to taxpayers completing 1031 exchanges.

Under section 1031, a taxpayer may defer gain recognition by exchanging for like-kind property. The replacement property cost must equal or exceed the net sales price of the relinquished property and the taxpayer must replace all debt and equity. To successfully complete the exchange, the taxpayer must meet certain requirements. Specifically, he or she must identify potential replacement property within 45 days of selling the relinquished property.

Finding an attractive replacement property in the right price range in such a short time can be difficult, and a taxpayer must take title to the property he or she ultimately buys in the same manner as the relinquished property. (For example, a taxpayer tired of the hassles of owning and managing a rental house cannot exchange it for a partnership interest in a professionally managed shopping center.) This title requirement often precludes taxpayers from buying a share in a larger, potentially more attractive property.

In response to the need for “ready-to-buy” investment products that taxpayers could purchase with varying amounts of cash and debt, a small group of companies began offering TIC interests as replacement property. To address the title issue, they used a co-ownership structure. Despite this arrangement, many CPAs were still concerned the IRS might see the TIC interests as essentially partnership interests, jeopardizing the benefits of an exchange.

After declining to answer several letter ruling requests on this matter, the IRS decided not to issue any more rulings pending further review. Revenue procedure 2002-22 is the result of this review. Although the IRS did not establish a safe harbor provision, it did spell out some requirements for TIC interests to qualify as co-ownership interests.

The maximum number of tenants-in-common permitted is 35.

The sponsor or organizer of the interests may own the property (or an interest therein) for only six months before selling 100% of the units.

Unanimous decisions are required on anything of material or economic impact to the property or its owners.

The management agreement (if applicable) must be at a market rate and renewable annually.

The pronouncement urges taxpayers wanting a definitive blessing on a particular product to seek a letter ruling. The IRS will make such a ruling based on the specific facts of the TIC offering.

Observation. Given this new information, many companies selling TIC interests are likely to structure their offerings to comply with the new guidelines, as well as seek an individual blessing from the IRS on their product. For the group offering the product, revenue procedure 2002-22 appears to provide a foundation to build on. For taxpayers, the guidance opens the door to a new product that may allow them more choice and flexibility when completing a section 1031 exchange.

—Ronald L. Raitz, CCIM, president, Real Estate Exchange Services in Marietta, Georgia, rraitz@rees1031.com . Rob Hannah, president, Tax Strategies Group in Chicago, rhannah@tsgrouponline.com .

TAX BRIEF

In today’s economy, thousands of people are unemployed. While looking for work, many have returned to college to improve their skills and to make themselves more competitive in the job market. It’s likely many of these taxpayers are unsure if they can deduct the cost of this education on their federal tax return.

Deductible education expenses are defined in Treasury regulations section 1.162-5. They include costs the individual incurs to maintain or improve skills required in his or her employment or other trade or business. This confuses many taxpayers because being unemployed would seem to eliminate any possible deduction. However, assuming the education meets the requirement of maintaining or improving skills required in their profession and the taxpayer meets certain tests, such expenses may in fact be tax deductible.

A taxpayer who is temporarily unemployed under certain circumstances may fall within the description of someone who is employed or conducting a trade or business. The Tax Court has held that someone who temporarily ceases to actively participate in a trade or business during a transition period between one job and another may be “carrying on” a trade or business during that time ( Haft v. Commissioner, 40 TC 2, 1963). The taxpayer may have to prove he or she was established in a trade or business before attending school. A petitioner was in his position for two years; the court found on the facts that this was a sufficient period to have been established in his employment. ( Sherman , 36 TC Memo 1191).

The Seventh Circuit Court of Appeals previously had held that a taxpayer who leaves a position temporarily to attend school full time may be carrying on a trade or business while in school. In Furner v. Commissioner (68-1 USTC 9234, 393 F2d 292, 1968, rev’g 47 TC 165, 1966), a teacher requested—but was denied—a leave of absence to attend graduate school. She resigned, and after completing her graduate education took a different teaching job at another school. The court found the taxpayer was carrying on her trade or business of being a teacher while she was in graduate school.

In John Gallo, 75 TC Memo 1963, a civilian employee of the Army and Air Force Exchange Service left his position to pursue a master’s degree after being denied a leave of absence. When he left his job he had completed his specified employment period, was no longer under an employment contract and did not receive a salary. His employer denied his later reemployment application because of a reduction in personnel.

The Tax Court cited Haft and Furner in finding that an approved leave of absence is not essential to be considered as carrying on a trade or business while attending school; nor is it essential to return to the same position after completing school. The court said even an unemployed taxpayer may be considered to be carrying on a trade or business if he or she was previously involved with and intended to return to it. To take advantage of this “hiatus principle,” however, a taxpayer must show that during the hiatus he or she had intended to resume the same trade or business.

The key factor in qualifying for the education deduction is intent to return to the same trade or business or employment. This does not mean the taxpayer must return to the same employer or to an identical job. The person must intend to return to the same or similar employment with the same or similar responsibilities that requires similar skills and training. But CPAs should beware that education that qualifies the person for a new trade, business or employment is not deductible, regardless of intent. To establish intent to continue in the same trade or business, clients should document efforts to obtain employment. The ultimate evidence of intent would be actual reemployment.

Regarding the meaning of “temporarily,” in revenue ruling 68-591, 1968-2 CB 73, the IRS said it would follow Furner in situations where an individual temporarily ceased to engage actively in employment to undertake education or training to maintain or improve required skills. While the IRS defines temporarily as a period of a year or less, the Tax Court has said there is no magic in a one-year limit on “temporary” and a facts-and-circumstances test is appropriate to determine whether a hiatus is temporary rather than indefinite. The unemployment period of a person whose employment ended involuntarily but who actively pursues employment, whether with the same employer or any other, should qualify under the hiatus principle as being a temporary absence. Given the decisions discussed here, it would not be beyond reason to believe a person could even discontinue the search for a reasonable period of time while obtaining additional education. Again, clients should document their efforts to obtain employment to establish the reasonableness of the hiatus.

Observation. The focus here is on determining whether an individual’s education expenses qualify as deductible under regulations section 1.162-5. If they do, CPAs should be cautious of two overriding factors in the regulations that eliminate any hope for the deduction:

The education must not be obtained to meet the minimum education requirement for the taxpayer’s employment.

The education must not qualify the individual for a new trade or business (a mere change of duties in the same general type of work does not constitute a new trade or business).

—Ronald J. Blair, CPA, director of financial affairs, School of Management and lecturer in federal taxation, University of Texas at Dallas.

TAX CASE

The tax law provides relief for taxpayers that reinvest money obtained from an involuntary conversion. Because the nature of involuntary conversions varies in different industries, taxpayers constantly confront new situations. The Tax Court recently considered the question of an involuntary conversion in the timber industry.

Willamette Industries is a forest products company that owns timberland it converts to lumber, paper and the like. From 1992 to 1995, ice, windstorms, wildfires and insect infestations damaged the trees Willamette was growing for future harvesting. To avoid further losses, it harvested and processed the damaged trees as if they were fully mature. On its corporate tax returns, the company treated the difference between its basis in the trees and their value at the time of the harvest as an involuntary conversion eligible for deferment under IRC section 1033.

The government denied Willamette Industries deferral treatment on the grounds section 1033 applied only to gains that stemmed directly from a casualty. The company responded it was compelled to harvest the trees early and therefore was entitled to involuntary conversion treatment.

Result. For the taxpayer. The legislative history of section 1033 indicates the rule was designed for taxpayers that reinvested the proceeds from an involuntary conversion in qualified business property. There is little dispute if the property is completely destroyed. However, numerous questions arise when property is only partially destroyed. A review of the early case law involving partial destruction points out two requirements for claiming an involuntary conversion:

The property must be damaged.

The damage is such that the property is no longer suitable for its intended purpose.

The government originally had ruled that the involuntary conversion of timber required the trees to be directly converted into cash. In revenue ruling 80-175, however, it changed its position and allowed the sale of damaged timber to qualify for section 1033 treatment.

The Tax Court concluded the government’s position in the current case was an attempt to reestablish a direct conversion requirement before permitting an involuntary conversion. The court rejected this effort. To qualify, a taxpayer must show that unexpected damage occurred that prevented it from using the asset as originally intended. The fact that Willamette chose to process the damaged timber rather than sell it doesn’t change the fact that the timber was damaged—forcing the company to use the trees before the normal time. Therefore a valid involuntary conversion had taken place.

The court raised an interesting question in a footnote. Section 1033 requires taxpayers to reinvest the proceeds in qualified replacement property. Given that Willamette processed the trees rather than sold them, how would it demonstrate compliance with the reinvestment requirement? Since the IRS did not raise the question, the court did not address the issue.

Although this case involved timber, it applies to all taxpayers that suffer partial damage to their property that prevents them from using it as originally intended. The method of converting the damaged property to cash no longer should prevent a taxpayer from receiving the benefits of involuntary conversion treatment. It will not have to show it converted the property directly to cash to qualify for tax deferral. However, the taxpayer must be able to prove it reinvested the proceeds in qualified replacement property if the IRS raises the question.

Willamette Industries Inc. v. Commissioner, 118 TC no. 7.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

Help for Terrorism Victims
The IRS released Publication 3920, Tax Relief for Victims of Terrorist Attacks. It explains how individuals can file claims under the Victims of Terrorism Tax Relief Act of 2001 (See JofA, Tax Matters, Apr.02, page 88). Taxpayers (and their survivors) eligible for significant income and estate tax relief include victims of the attacks on the World Trade Center, the Pentagon and United Airlines Flight 93; the anthrax attacks; and the Oklahoma City bombing.

Under the act, a victim’s federal income taxes are forgiven for the year of the terrorist attack and for the preceding year. The minimum refund is $10,000—even for victims who owed no taxes.

Publication 3920 contains worksheets CPAs can use to help victims and their families determine the amount of tax forgiven. It also covers required documentation and where taxpayers should send their returns (IR-2002-23 (2-25-02)).

No Tax on Frequent Flyer Miles
It’s official. The IRS finally formalized its hands-off approach to frequent flyer miles. In announcement 2002-18, the service said it will not assert that a taxpayer has understated his or her federal tax liability by personally receiving or using frequent flyer miles or other promotional benefits (such as incentives from hotels and car-rental agencies) related to the taxpayer’s business or official (government-related) travel.

In the past, business travelers whose employers allowed them to keep and use such miles for personal travel feared the IRS would try to tax the value of these perks. Those taxpayers now can put such fears aside. However, employees must include in income any promotional benefits converted to cash or compensation paid in the form of travel.

Enter and Sign In, Please
In the wake of the September 11 terrorist attacks, many corporations are requiring IRS agents to provide personal information (Social Security number, home address, home phone number and driver’s license) before allowing them access for on-site audits. However, according to internal legal memorandum 200206054, disclosure of this information contravenes IRS authority under IRC section 7602 to set the time and place of an audit; according to the government, taxpayers cannot determine the conditions under which the IRS conducts an investigation. Agents need give only their names and IRS-supplied identifying number to gain access for an on-site audit. However, a taxpayer can ask IRS employees to wear company-provided badges while on corporate premises.

The memo instructs agents not to leave their IRS credentials with the company’s security force or allow them to be copied. Agents are urged to move the examination to the local IRS office if taxpayers refuse to allow an agent on site without revealing personal information.

Meal Deduction Limits
Over a five-year period, a corporation deducted 50% of its annual meal and entertainment expenses, as provided in IRC section 274(n). The corporation discovered it could have deducted some of the expenses in full. It estimated it incurred costs for more than 50,000 meals and entertainment items for each of the five years in question. The corporation wanted to amend its affected returns and deduct the correct amount. It asked the IRS if it could use statistical sampling techniques to estimate what percentage of the total expenses was exempt from the 50% limitation. The corporation cited a litigation guideline memorandum (LGM TL 97 (9-9-92), Use of Statistical Sampling Techniques in Examination of Tax Returns ) which allows both the IRS and taxpayers to rely on sampling techniques.

The government said section 274(d) imposes strict substantiation requirements for meal and entertainment expenses (the amount, time, place and business purpose of the expenditure plus documentary evidence). According to field service advice 200209028, the IRS decided a statistical sampling approach to substantiate meals and entertainment expenditures did not satisfy the strict requirements of section 274(d).

Assignment of Partial Interest
A taxpayer wanted to purchase a single-premium whole life insurance policy on his life and name a charity as its irrevocable beneficiary. He intended to immediately transfer to the charity all privileges, rights and interests in the policy while retaining only bare legal title. State insurance regulations prevented the taxpayer—who had 30 days after purchase to cancel the policy—from transferring title to the charity. The taxpayer asked the IRS if he could deduct the premium as a charitable contribution.

In the past, the IRS has denied a deduction when a taxpayer assigned a partial interest in an insurance policy to a charity. IRC section 170(f)(3) requires the taxpayer transfer his or her entire interest. However, according to revenue ruling 75-66, 1975-1 CB 85, the partial interest rule applies only if the taxpayer retains a substantial interest in the property.

In letter ruling 200209020, the IRS ruled that retaining bare legal title is not retention of a substantial right. Therefore, the taxpayer is allowed a charitable deduction but only after the cancellation period expires.

Deductibility of “Impact” Fees
A real estate developer purchased some unimproved land on which he intended to construct multifamily homes. The local government imposed an “impact fee” on the project—a one-time charge to finance specific off-site capital improvements for general public use (schools, water, police and fire) necessitated by the new development. The amount of the fee depended on the buildings’ size and the number of rental units. The developer paid the fee when the construction permit was issued.

For tax purposes, the developer wanted to know whether he could deduct such fees currently or if he should add them to the basis of the nondepreciable land or capitalize and add them to the depreciable basis of the buildings.

In revenue ruling 2002-9, IR-2002-20, the IRS determined the impact fees would result in a permanent improvement or betterment to the development projects and thus should be capitalized as part of the cost of the building under IRC section 263(a). If the building qualified as low-income housing, the impact fee could also be included in the basis for purposes of the IRC section 42 low-income housing credit.

Shareholder’s Personal Legal Fees
A shareholder in a video corporation was indicted on federal criminal charges of conspiracy to obstruct the lawful functions of the IRS. The shareholder eventually pleaded guilty to the charge. The corporation was not a defendant in the criminal case. However, it paid the shareholder’s personal legal fees and deducted them as an ordinary and necessary business expense on the corporate return. The IRS disallowed the deduction and issued a deficiency notice to the shareholder, treating the payment as a constructive dividend.

The Tax Court agreed with the government. It said the corporation could not deduct the shareholder’s personal expenses unless they were paid to protect the business or the criminal activity sufficiently related to the business. The court ruled the payment of the legal fees conferred an economic benefit on the shareholder without an expectation of repayment, resulting in a constructive dividend to him.

The court also said the shareholder could not deduct the legal fee as a miscellaneous itemized deduction because he failed to show the deduction was business related (TC Memo 2002-40).

—Michael Lynch, CPA, JD, professor of tax accounting at Bryant College, Smithfield, Rhode Island.